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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Month: October 2010

As with anything in economic forecasting, what I am about to say is at best an educated guess. Given the present environment, where is the global economy likely to go?

Any analysis like this has to contend with political factors that drive the major imbalances of the global economy. Here are the imbalances as I see them:

China insists on keeping its currency cheap in order to promote employment at home.

The US does not care about deficits or currency debasement, as it seeks Keynesian remedies to its economic crises. (Little realizing that they are making things worse…)

The Eurozone protects profligate euro-fringe nations, at the possible cost of destroying the Eurozone as a whole.

If China will not allow its currency to strengthen, well then, the path of least resistance is for the US to debase its currency, leading the world in a cycle of competitive debasement/inflation. Since many nations want to be net exporters, US Dollar weakness is responded to through debasement, or purchase of US Dollar assets.

Putting it simply, the path of least resistance is inflation. Reduce the value of nominal debts in real terms. Eliminate underwater debts by raising the nominal prices of the collateral.

Now, surplus nations like China and Germany will resist this, but I suspect they will be dragged to this, kicking and screaming.

We are in the process of trying the alternative approach to solving the Great Depression via inflation, which will have a different set of problems than the foolishness of FDR. The problem is too much debt, which needs to be changed into equity, but government tinkering discourages compromises.

Rather than the deflation that characterized the Great Depression, inflation may be what drives the future. The question could be “how much?”

But all that said, there are other possibilities. We could raise taxes and pay off the debt. We could default on the debt. Neither of these are favored by current politics, but they could happen.

So as you invest, consider an inflationary bias. I think it is the likely wave of the future.

For the most part these are rules that would only serve a value investor. They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which rules 7 and 8 spell out. The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors. Value traps are companies that are cheap, but cheap for a reason. How do you avoid value traps?

Try to have industry factors working for you (Rule 1)

Look for companies that still have some room to grow (Rule 4)

Avoid companies that are aggressive in their reporting of income (Rule 5)

Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together. They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series. From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

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Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

Many investors are undisciplined when they make decisions to add stocks to their portfolios. They see what they think is a neat idea, and they add it to their portfolios.

Don’t think that it is that much better in institutional investing. Often Chief Investment Officers, and portfolio managers react to news cycle, and demand action from their analysts when the analysts are behind the curve. That is not a time to ask for action. Once an event has happened, it’s too late. Ignore it, and move on.

You might say to me, “But wait! There is new information here the changes our opinion about everything! We have to make portfolio changes here!” Okay, take a deep breath and ask yourself the following question, “At current prices, which have reacted to the change in the news, what advantages do you have relative to all of your competitors who have all seen the same news?”

Most the time, after an event has taken place, there is little advantage to investing in securities that are affected by the event. The objective of an investor is to get ahead of the curve. Far better to ask, “What is not being noticed by the market here?” That’s what I do when I do my industry studies. I try to get away from the short term news flow, and ask “Where will things be three years from now?”

Yeah, that’s tough to do. But why play games where we chase our tail by trying to gain an advantage off of current news flow? That is a loser’s game.

That is why I deliberately try to slow things down when I am making changes to the portfolio. I take action in changing the portfolio 3 to 4 times a year and when I make changes, I tend to trade three or four stocks. An approach like this gives me roughly a 30% per year turnover rate.

Ganging up decisions like this forces decisions to be more dispassionate, and not subject to news flow. It forces me to look at valuation metrics, momentum, industry factors, and sentiment factors. By the time I am done, I will have identified a group of companies in my current portfolio that are not as good for future performance as a group of new companies that I have identified.

Where do those new companies come from? Often they come from my industry studies. I will go through those industries and look for attractive names. I will then add them to the list of candidates. Sometimes they come from my reading. I will read an article and say, “That’s a good company. Add it to the list.” At other times I’ve seen article that runs a screen that I think is interesting; I will add those names to the list also. And, if I’m really scraping the bottom of the barrel, I will run a variation of Ben Graham’s screen that combines price-to-earnings and price-to-book, and add in the names that look interesting.

When I do the grand comparison, I take all the names that are in the portfolio already and compare them against the replacement candidates. I rank them on a wide variety of valuation factors, some sentiment factors, and momentum. Before I start the process, I look at all the factors and ask how important they are in the current environment. What is scarce? What is common? I give more weight to what is scarce and less weight to what is common. If there is significant momentum in any factor, I ask how long momentum has been there, and whether it is getting tired, or showing signs of blowing off. Most of the time, if there is momentum in a factor, I will give it more weight. But if it is getting long in the tooth, I will drop the weight of that factor. If the momentum is crazy, I will drop the weight of that factor. Normal momentum is a positive. Failing or crazy momentum is negative.

Once I have my factor ranks, and I have weights for my factors, I can then calculate grand ranks. Then I sort the entire portfolio and replacement candidates on the grand ranks, and I look for the median stock currently in my portfolio. I look below that stock for companies in my portfolio to trade away. I look above that stock for candidates to add to my portfolio.

Now comes the hard part. I look at the financials of each of the replacement candidates. In most cases I end up finding that there is something wrong with the company and that is why it is so cheap. But usually I find three or four names that are cheap for no good reason. I buy them, and sell away companies that are relatively rich in my portfolio.

That does not guarantee that I have best portfolio in the world, but it does mean that I have a better portfolio, most likely, than I had before. And, if you can to improve your portfolio quarter after quarter, your portfolio will deliver good results.

And so far, that is what my portfolio rules have done for me. I’m done with the eight rules, but I will close this series of posts on how the eight rules work together.

PS – I always wanted to complete a series when I was writing for RealMoney.com, where I would explain all of my eight rules. Now I have done so. And, you have gotten it for free. Such a deal.

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Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Let me begin with the last part of the rule. I’ve gotten different reactions over the years from holding 30-something names my portfolio. From some friends who run concentrated hedge funds they say, “Why so diversified?” From those that run mutual funds they say, “Why so concentrated?”

Since I concentrate industries, owning 30 to 40 names my portfolio is relatively undiversified, compared to an index fund. My view is that industry performance is the main driver of stock performance. I also think that owning industries in proportion to the index is a recipe for mediocre performance. If you don’t break free from the industry weights of the index, you will never achieve index beating performance.

Now, some may criticize the idea that I don’t know what my best ideas are. Good, go ahead and criticize. My experience has been that ideas that I thought were marginal often did quite well and ideas that were highly promising sometimes did marginally. On the whole I think there was some rough positive correlation between how well I thought it would do, and how it actually did, but not enough to make me change this rule.

I do occasionally make a name for my portfolio a double-weight, or once even a triple-weight, but those are rare. To have a high weight in my portfolio means that it must be exceptionally cheap, and be exceptionally safe. In other words, it must be very, very, misunderstood.

At present I have 34 names my portfolio. Ordinarily I like to have 35. But, I don’t change the number rapidly. I have a greater tendency to raise the number when the market is cheap, and I add equity exposure. That said, during the bear market from 2000 to 2002, I decreased the number of names as the selloff got worse, concentrating into the names that got hit the hardest that still deserved to be invested in. As the market began to rise, I added to the number of names that I invested in.

Keeping the number of names relatively fixed in the short run helps to facilitate swap transactions. Swap transactions are a more intelligent way of managing an equity portfolio, because people are reasonably good at doing binary decisions, and not at doing decisions that have a lot of degrees of freedom.

I can’t tell you at any given point in time that I have the best set of stocks in the world. But, it is relatively easy for me to look at the stocks that I am buying versus the stocks that I am selling, and conclude that I am coming up with a better portfolio as a result. More on that when I discuss portfolio eight.

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Now, on to rebalancing. I have gotten some criticism over the years, arguing that my rebalancing discipline leads me to pump money into losers that lose yet more. Part of the misunderstanding is that when a stock falls by 20%, it doesn’t trigger an automatic buy, but an automatic review. If my review comes the conclusion that the stock is fundamentally okay, then I rebalance up to the target weight. I don’t double the position; that would be lunacy. I only add to bring it up to target weight. This is a moderate and disciplined way to buy weakness.

If my review finds that I made a fundamental mistake, I sell the position out. Now, all that said, my worst losses typically came from cases where I rebalanced down and rebalanced down, and never caught the fundamental error. Hey, I’m human. But I can say that my gains more than paid for my losses. Also, most of the companies that hurt me had balance sheets that were less strong then I thought.

When I was on the other side of the table, choosing investment managers, I ran across three managers with excellent track records that used this strategy. They felt that it added on 1-3%/year. Surprisingly, one was a growth manager, one was a core manager, and one was a value manager.

My sense is this: markets oscillate, and performance by industry and company oscillates. This simple strategy catches some of those oscillations, buy low and selling high.

It also helps portfolio management from a psychological standpoint, because you realize that by realizing gains partially, and buying lower selectively, you don’t care so much about day-to-day fluctuations. Rather, you realize that on average, fluctuations are working for you, and so, you focus on fundamentals, not the noise.

At least, that is what I have experienced. And that is why I rebalance.

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Over the last year, I noticed that my personal insurance carrier had raised my rates, for the third year in a row, with no change in any variable affecting insurability. Now, having been an insurance equity analyst, knowing what their pricing strategy was made me suspect that this might happen. Essentially, the insurer quotes a teaser rate, and slowly grades into the real rate over time, while mentioning loyalty bonuses to long-term clients.

I finally got fed up, and decided to bid out my auto, home, and umbrella coverages. I talked with seven companies, sent them PDF files of my coverages, answered questions about what was not in the PDFs, and now have five bids on my business. At minimum I will cut $500/year off of my premium, and at maximum, $1500/year.

One surprise in the process is that the insurance companies underwrite very differently. I was surprised at how many insurers asked questions that no other company did. What that means to the average consumer, is that it would pay to bid out your personal insurance business every five years or so. You could save a lot.

Those differences in underwriting mean there are potentially opportunities for better rates. The differences in underwriting mean that some insurance company won’t catch one of your most prominent risk factors, and you will get a lower rate.

You might be with your best insurance carrier now, but test it – there might be a better deal for you. Check local and national firms. Try some mutual companies as well as stock companies; the economics sometimes varies. If you tend to go to the name-brand firms with a captive agency force, toss in an independent agent.

And, consider upsizing your deductibles. Insurance works least well when it is used for fixing small problems; it is meant for true disasters. Self-insure the small stuff, and don’t cheat by not having a stash of liquid assets to tap.

As an aside, I do the same thing with health insurance. I have an HSA with a $5000/year deductible. I contribute the maximum each year, and pay health costs out of pocket, never tapping the HSA for healthcare. I get a tax deduction on the money going in, it accrues tax-free, and it comes out tax-free. The tax benefits were so great that I turned down the health coverage from my last firm.

But back to the main point, to summarize: it pays to shop your personal lines insurance every five years or so. The same is true of term life insurance if you are still healthy, every ten years or so. And consider raising your deductibles to a level where the insurance kicks in only if there is real pain.

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Well, I got a surprise today. No, it wasn’t that my favorite life reinsurer, RGA, beat the earnings estimate handily. Rather, it was that the Securities Division of the Attorney General’s office of the State of Maryland made my filing effective to be registered as an investment advisor in the state of Maryland. What I expected to take six weeks, or even two months, ended up taking seven days. (That said, I had to go back and forth with Maryland three times, but each time I responded to them in less than 90 minutes. All my preparation made me ready for the challenge.)

That left me shocked, happy, and then saying, “Wait, I could get started sooner if I had a custodian chosen.” But patience is needed here. I face an interesting choice in who to use. I have five candidates, and from a birds-eye view, they divide into three groups. Two are inexpensive, two are expensive, and one is so complex that I can’t figure out what it is.

Now, naturally, the expensive ones offer more services, but I can’t tell how valuable they are. The one I can’t figure out claims their automated trading algorithms more than pay for themselves. I’m leaning toward the cheap ones because I am good with math, and until I get so many clients that I am going nuts, that would be best for my clients. (I’ve created far more complex systems while programming as an actuary. This stuff is trivial. Why not save money for my clients? After all, I’m here to serve them, right?)

But that is my challenge at present. What I am going to do is ask each firm to give me a “demo” of their services, and try to get the odd one to clarify their pricing. I will choose the one that will allow me to give the best service to my investors.

One intangible asset that I prize is my readers, and I thank them for their many comments and e-mails, even though I can’t respond to all of them. With that, I pose the question to my readers who have faced the decision that I am making: Is it worth paying more in commissions to get higher services that might benefit your clients? My guess is no, but I am open to being educated.

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In the end, economic systems work, and judicial systems modify to accommodate that. The only exception to that is when a culture is dying.

I have been scratching my head over all the problems in the residential mortgage market. How can foreclosure take place, when there is no note, properly endorsed, to display? How can certificate holders of securitizations be comfortable when the transfer of ownership interests in mortgages was never completed.

But, I’m not all that worried. In one sense, the bigger the problem, the easier it is to solve. Why? Because the political systems that surround the economic systems tend to focus better on big problems than little problems.

As in Cordwainer Smith’s “The Instrumentality of Man,” the first priority of any government is to survive. This is one reason why it is easier for them to survive large crises than small problems. That’s why I give Rudy Giuliani relatively little credit for what he did on 9/11, but give him more credit for what he dealt with on budget issues.

In large crises, the range of options becomes limited. Also, it becomes easier to see which option is the best one.

So, given the systematic and severe errors that occurred in residential mortgage securitization, shouldn’t there be an obvious answer to what must be done now? Yes, but a solution here will take time. Banks will have to make the effort to secure the notes that allow them to foreclose. And then, they will foreclose. Will that mean a lot of upset for the residential property market in the short run? Yes. Will the residential property market survive this? Yes.

Foreclosures will take place. But the legal niceties that protect our property rights in other areas must be observed by the banks. Courts should not give in to pressure that they must do something to preserve the proper functioning of the market. Yo, courts. The markets will survive even if you delay. Take your time and do it right. Yo, lenders; delay is the price for not having done it right in the first place.

As for the securitization certificateholders, let me remind you of the investment banks and AIG. AIG absorbed subprime mortgage risk from all of the investment banks. The investment banks thought they were pretty clever, until they realized that they all had taken advantage of AIG, and thus, AIG might not be able to make good on all the risks that they had absorbed.

In the same way, if all residential mortgage-backed securitizations are unwound at the same time, the sponsors of the mortgage-backed securitizations will not be able to make good on their obligations.

As I see it, residential mortgage-backed certificate holders have an incentive to work with the sponsors to see how this crisis can be worked through. And as I see it, perhaps the solution is to pay a consent fee to the certificate holders in exchange for waiving their rights to sue over the malfeasance of not transferring the notes from the originator all the way to the trust.

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As with other crises, the probability of total failure is remote. Total failure only occurs when those at the top of the power structure are so self consumed that they do not see the threat to their lives.

That’s why I see a slow but reasonable solution coming through the court system to solve the malfeasance engendered through the sloppy execution of securitizations. Yes, things are bad. Yes, our current politicians are clueless. But there is enough interest in coming to a solution for society as a whole that an equitable solution will be arrived at in the courts – not through Congress, not through the President.

That doesn’t mean that things won’t be choppy and messy. Indeed, there will be many ugly times en route to a solution. But things are not so bad in our judicial systems, as a whole, that we will not come to the correct solution, after exhausting all imaginable alternatives.

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I am more optimistic over how my asset management practice will start. Thanks to all who have expressed interest. Depending on how the state of Maryland replies to my filings, I will be able to get started sometime in November, December or January. At present I am interviewing custodians who be clearing brokers.

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Cash flow is the lifeblood of business. In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

I want to avoid companies that do big scale acquisitions. Large acquisitions tend to waste money.

I also want to avoid companies that do acquisitions that are totally unrelated to their existing business. Those also waste money.

I want to avoid companies that buy back stock at all costs. They waste money by paying more for the stock than the company is worth.

This was common in the 50s and 60s but not common today, but who can tell what the future will hold? I want to avoid companies that pay dividends that they cannot support.

Intelligent companies pay a reasonable fraction of the earnings as dividends. They only buy back stock when their stock is cheap. They don’t buy their stock back when their stock is sort of cheap. They only buy it back when it is cheap.

And as for mergers and acquisitions, intelligent companies don’t do large-scale acquisitions. Instead, they do little infill acquisitions. They do acquisitions that give them a new technology to extend their business. They do acquisitions that give them new markets distribute their products or services through. In general, they do acquisitions that allow them to grow more effectively organically.

Organic growth is what it’s all about. Anyone can do a stupid acquisition, and give the appearance of growth, but real organic growth is hard to find; it is the acid test of determining what is a good management and what isn’t.

That brings another point to mind. Unlike many investors, I don’t mind if intelligent managements hang onto cash. Cash is valuable in the hands of the bright men. It gives them flexibility during times of economic stress. Giving intelligent management teams additional flexibility is a good thing.

When you hear the phrase “transformational merger,” hang onto your wallet. Most big mergers do not achieve the goals that they were designed to achieve. And as I said before, the best management teams are not looking to grow rapidly through mergers and acquisitions. Rather, they do little acquisitions to facilitate organic growth.

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There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset. If a risk control model has an asset becoming more risky when prices fall, it is wrong.

After doing my talk for the Society of Actuaries last Wednesday, I got inspired to write something about modern portfolio theory, the capital asset pricing model, the efficient markets hypothesis, etc. This particular rule deals with two things:

The same event can have different risk for different individuals. Risk is unique to each individual. It cannot be summarized by a single statistic for comparative purposes across individuals.

In general, with a few exceptions, risk is inverse to price. As the price gets higher, so does risk. As the price gets lower, so does risk. The major exception to this rule is when trends are underdiscounted, because estimates of intrinsic value are flawed.

Let’s deal with these issues one at a time. Start with a simple question. Why do academics want to have a single measure for risk? It allows them to write papers, and it keeps the math simple. That’s why we have concepts like beta and standard deviation of total return. It’s why we have concepts like the Sharpe ratio and other ratios that purport to measure return versus risk.

If our total planning horizon was similar to the periods that these figures are calculated over, they might have some validity. But most of the time are planning horizons are longer than the periods that these figures are calculated over. Even worse, most of these statistics are not stable. The value calculated today may likely have a statistically significant difference from the value calculated a year ago.

But what is worse still is the idea that by taking more risk you will get more return. If anything, the empirical research that I’ve been reading, and the value investors that I have talked to, indicate that the less risk you take, the more you’ll make. A good example of that would be Eric Falkenstein and his book Finding Alpha. Minimum beta and minimum standard deviation portfolios tend to outperform the market. Junk grade bonds tend to underperform investment-grade bonds.

If it hurts too much, don’t do what I’m about to say. Think about Lenny Dykstra. When he and I were writing at RealMoney.com at the same time, I would often ask him about what his method would be to control risk. He never gave me a good answer; actually he never ever gave me an answer at all.

My concern was for small investors, dazzled by the celebrity, and the simple approach that he would take that seemingly yielded huge profits, would adopt the approach, and not know what to do when things went wrong. For Dykstra, who seemingly had a lot of money, losing a little on a deep in the money call trade would not hurt him much. But to an unfortunate average guy reading Dykstra’s work, a similar sized loss could be very painful.

That said, that greatest risk was in plain view, which Steve Smith, I, and a few others went after — Larry didn’t know what he was talking about.

Risk varies by differences in wealth; risk varies with age. Risk varies with the level of fixed commitments you have in life. To give you an example there, when I went to work for a hedge fund, the first thing I did was pay off my mortgage so that I would feel free to take big risks for the hedge fund. It is far harder to take risk, the higher the level of fixed obligations that one must pay month after month.

To make it more practical, think of all the malarkey that has been spilled talking about “animal spirits.” I don’t believe that businessmen are irrational; many Keynesian economists are irrational, but no, not businessmen. Businessmen will not take risks when they are overleveraged, or, when a broad base of their customers is overleveraged.

Risk is unique to everyone’s individual situation. Any time you hear someone bring up risk factors that are generic, you can either ignore them, or, more charitably think that they have a proxy that might have something to do with risk, maybe.

Go back to Buffett’s dictum: far better to have a bumpy 15% return than a smooth 12% return.

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The second part of the rule says that risk models should reflect higher risk as prices rise and lower risks as prices fall. The implicit idea behind this is that it is possible to calculate the intrinsic value of an asset. Can I disagree with one of my own rules? Well, since I do the writing here, I guess I get to make up the rules about the rules.

There are many assets that it is difficult calculate the intrinsic value thereof. Examples would include commodities, growth stocks, and anything that is highly volatile.

Though I believe my rule is correct most the time, markets are subject to momentum effects. Often when a stock is at its 52-week high, that’s a good time to buy, because people are slow to react to changes in information. And, when stock is falling hard, and is at a 52-week low, that is often a good time to not buy the stock, because there are maybe bits of information about the stock, or its holders, that you don’t know.

In general, though, higher prices are more likely to be overpayment and lower prices are more likely to indicate bargains. Why? Because returns on equity tend to mean revert. Companies with poor returns on equity tend to find ways to improve business. Companies with high returns on equity tend to find increased competition.

Thus, as always, I counsel caution. Don’t ignore momentum, but also don’t ignore valuation. Ask yourself how much upside there could reasonably be, and how much downside. Play where the downside is limited relative to the upside, because the key to investing is margin of safety. Play to win, yes, but even more, play to survive, so that you can play longer.

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I general, I think our tax code is nuts, allowing deductions for interest, and not dividends. That creates a pro-debt bias in the tax code, which we are suffering from now. I would reverse it, and allow deductions for dividends, and not interest, which would create a pro-equity tax code.

Leaving that aside, though I think corporations should not be taxed, and individuals should be taxed more heavily, if you must tax corporations, do not create a separate tax accounting basis. There should be no social engineering through the tax code. Instead, tax corporations on their GAAP income. If there is some other figure that they highlight to investors, such as operating earnings, tax them on that.

A taxation method like this gets rid of two sets of games:

The game of lowering taxable income below GAAP income.

The game of boosting reported income above GAAP income.

It is far better for the nation as a whole to have one set of strict rules on taxation that are almost impossible to avoid that the Swiss cheese tax code that we have gotten post-Reagan. Discretion in the tax code allows the wealthy to avoid paying their fair share, regardless of what the tax rates are. Why do you think wealthy Democrats support increases in tax rates and estate taxes? Because they have clever ways of avoiding those taxes.

Again, I support true tax reform. But who else would support such a fair system, when politicians support unfairness to aid them in getting re-elected?